Discount Shopping with Closed-End Funds
Even investors like to go bargain hunting. Discounts had a higher rating than long-term stability and income among financial advisors and investors polled in a recent Aberdeen survey. About 54% of those polled believe that purchase discounts to net asset value (NAV) are the most attractive benefit of investing in closed-end funds (CEF).1
Closed-end funds are investment vehicles with a 120-year history but often lose out in the popularity contest to mutual funds and newer-to-the-scene exchange-traded funds (ETFs). A possible explanation for this could be the perception that the unique structure of closed-end funds are complex and difficult to understand.2
However, by understanding the basics and core concepts of what differentiates a closed-end fund, investors can make the most of available market opportunities. Closed-end funds are usually seen in client portfolios managed by financial advisers with the largest books of business. In a few simple paragraphs, you can also learn how to take advantage of these sophisticated investments.
First, let us understand what a closed-end fund is and how it is structured. Like an open-end mutual fund, closed-end funds invest in a portfolio of securities pursuant to a specific investment object and strategy. However, open-end mutual fund shares are purchased and sold from the Fund directly, which means funds can grow or shrink over time subject to investor demand.
Closed-end funds raise a fixed amount of capital from an initial public offering (IPO), and the fund’s shares are then listed and traded on a stock exchange. The shares of the funds are traded on the secondary market like any other listed equity security such as Google, Apple or GE.
Portfolio managers only trade the fund’s portfolio when making investment allocation decisions. There is no need to trade the portfolio to meet redemptions and sale activities. This greatly reduces transaction costs and enable portfolio managers to remain fully invested which in turn enhances the returns to investors.
Sales and purchases in open-end funds often increase during times of market volatility as investors risk appetites change. This can force investment managers to trade a fund’s portfolio when valuations are less attractive and trading costs are higher.
We believe the closed-end fund structure provides a number of benefits, such as the following:
- The fixed capital structure allows portfolio managers to take advantage of investment opportunities at times of market duress.
- As shareholder liquidity is provided via the secondary market, closed-end funds can also give investors access to less liquid or more thinly traded markets or sectors which would not be possible for professional active investment managers to deliver in an open-end fund structure.
- The fixed structure also enables closed-end funds to borrow or what is often referred to as leverage. Although leverage can result in greater share price volatility, leverage can help enhance returns. For example, it is particularly advantageous for fixed income funds which borrow at interest rates much lower than rates at which they can invest, increasing a fund’s income for the same portfolio of securities.
As closed-end fund shares are traded on the secondary market, the value of the shares is determined by the market, rather than the NAV of the Fund. Shares are said to trade at a discount when the share price is lower than the NAV, and at a premium when the share price is higher than the NAV. Whereas demand for an open fund manifests itself in a fund increasing or shrinking in size, demand for closed-end fund shares is reflected in changes to the discount or premium at which the Fund’s share price is relative to NAV. For instance, a closed-end fund trading at a 15% discount to NAV offers investors a chance to buy $1 worth of assets for 85 cents.
The nuance with closed-end funds is that instead of buying into one company, investors are buying into a certain asset class, sector or country. It’s a way for investors to make the most out of getting into other and even illiquid markets – on the cheap if it’s trading at a discount.
Why does discounting happen? Closed-end funds trade on a stock exchange, so it’s much like a stock going up and down. Discounts and premiums within the broader closed-end fund market rise and fall depending on business cycles and market sentiment. Discounts and premiums on individual closed-end funds are influenced by varying factors and can change over time.
Closed-end funds typically reach their widest margins during periods of market turbulence coupled with heightened investor pessimism. Discount widening can further expand in asset classes that have experienced elevated levels of underperformance in a given year. Widening discounts are one of the latest shifts that those polled in the aforementioned survey said they have been noticing in the space.
Widening discounts are also a way for investors to purchase closed-end funds below their fair market value during tax periods. Specifically, the effects of tax loss selling have historically been most prevalent during the 45-day period between November and mid-December. (Tax loss selling is the tactic that investors use for identifying and potentially liquidating underperforming funds to reduce tax burdens.)
With the historical trend of closed-end fund discounts narrowing during the defined period of consistent tax loss selling, investors can take advantage of the “sale” opportunity to get more out of their dollars during the holiday season. Market prices have tended to outperform NAVs toward the end of the year and into the early months of the following year.
Many investors find the discount element of closed-end funds attractive, but what else can these funds offer? Closed-end funds have primarily been viewed as income engines and another tool for portfolio diversification. Over longer market cycles, closed-end funds can potentially provide higher returns than some open-end mutual funds.
These historical trends align with Aberdeen’s survey results. Financial advisors and investors polled said they had a healthy view of closed-end funds over the long term, with about 70% having a positive sentiment.
This long-term mindset is useful for portfolio managers of closed-end funds, who find that the structure enables them to maintain a long-term view that minimizes the amount of cash required to meet shareholder redemptions. This is especially useful when investing in illiquid markets.
Where in the universe can closed-end funds invest? There pretty much is no limit. Aberdeen survey respondents cited a variety of asset classes when asked about which asset classes they would prefer to invest in through a closed-end fund.
When seeking to gain exposure to different markets through closed-end fund vehicles, more than one-third (about 37%) of those surveyed identified an interest in domestic markets. The second largest asset class of interest was emerging markets at 36%, followed by frontier markets at 17% and international developed markets at 10%.
Active management of closed-end funds can enhance the quality of these investments, which is why finding the right manager is crucial for investors looking to invest in closed-end funds. Today’s markets are turbulent regardless of how the economy is faring. This means identifying quality long-term investments requires adequate attention and keeping boots on the ground. At Aberdeen, we sit down with management at companies and spend years studying local markets through our teams based all over the world in which we invest. We believe this benefit of exposures aids us in better understanding these markets.
The complex nature of the regions where closed-end funds can invest requires breadth and depth of experience. Not to mention, the structure of closed-end funds are complex on its own. As a result, closed-end funds tend to be offered by highly experienced asset managers, which may give newer investors some comfort in exploring a new territory.
1 The Closed-End Funds Survey was commissioned by Aberdeen and an independent party. It was conducted on October 27, 2015 at the Pristine Advisers and CEF Network’s Fifth Annual Closed-End Fund Investment Strategies Conference in New York. The data is based on responses from 101 financial advisors and investors.
2 Closed-end funds are similar to mutual funds and exchange-traded funds (ETFs) in that they professionally manage portfolios of stocks, bonds or other investments. Unlike mutual funds and ETFs, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange. Open-end funds can be bought or sold at the end of each trading day at their net asset values (NAVs). Because closed-end funds and ETFs trade throughout the day on an exchange, the supply and demand for the shares determine their market price; closed-end funds’ and ETFs’ market prices may fluctuate through the trading day and those prices may be higher or lower than their NAVs. Closed-end funds, mutual funds and ETFs charge investors annual fees and expenses. Closed-end funds typically do not have sales-based share classes with different commission rates and annual fees. All three vehicles seek to deliver returns based on their investment objectives, but none of them are FDIC insured - share price, principal value, and returns will vary, and you may have a gain or a loss when you sell your shares. The Revenue Act of 1936 established guidelines for the taxation of funds, while the Investment Company Act of 1940 governs their structure. Aberdeen Asset Management does not provide tax or legal advice; please consult your tax and/or legal advisor.